Setelinleikkaus: When Finns snipped their cash in half to curb inflation

On the last day of 1945, with World War II finally behind it, Finland's government announced a new and very strange policy.

All Finns were required to take out a pair of scissors and snip their banknotes in half. This was known in Finland as setelinleikkaus, or banknote cutting. Anyone who owned any of the three largest denomination Finnish banknotes — the 5000 markka note, the 1000, or the 500 — was required to perform this operation immediately. The left side of the note could still be used to buy things, but at only half its value. So if a Finn had a 1000 markka note in their wallet, henceforth he or she could now only buy 500 markka worth of items at stores. As for the right side, it could no longer be spent and effectively became a bond (more on this later).

Source: Hallitus kansan kukkarolla, by Antti Heinonen

Setelinleikkaus was Finland's particular response to the post-War European problem of "monetary overhang," described in a 1990 paper by economists Rudi Dornbusch and Holger Wolf. After many years of war production, price controls, and rationing, European citizens had built-up a substantial chest of forced savings, or involuntary postponed consumption, as Dornbusch & Wolf refer to it. With WWII now over, Europeans would soon want to begin living as they had before, spending the balances they had accumulated on goods and services. Alas, with most factories having been configured to military purposes or having been bombed into dust, there wasn't nearly enough consumption items to make everyone happy.

It was plain to governments all across Europe what this sudden making-up of postponed consumption in a war-focused economy would lead to: a big one time jump in prices.

This may sound familiar to the modern day reader, since we just went through our own wartime economy of sorts: the 2020-21 battle against COVID and subsequent return to a peacetime economy. The supply chain problem caused by the COVID shutdowns combined with the big jump in spending as lockdowns expired, spurred on by a big overhang of unspent COVID support cheques, led to the steepest inflation in decades. 

According to Dornbusch and Wolf, European authorities fretted that the post-WWII jump in prices could very well spiral into something worse: all-out hyperinflation, as had happened after the first World War. Currencies were no longer linked to gold, after all, having lost that tether when the war started, or earlier, in response to the Great Depression. 

To prevent what they saw as imminent hyperinflation, almost all European countries began to enact monetary reforms. Finland's own unique reform — obliging their citizens to cut their stash of banknotes in two — would reduce the economy's stock of banknotes to just "lefts," thereby halving spending power and muting the wave of post-wartime spending. After February 16, 1946 the halves would be demonetized, but until then the Finns could continue to make purchases with them or bring them to the nearest bank to be converted into a new edition of the currency.

As for the right halves, they were to be transformed into a long-term investment. Finns were obligated to bring each right half in to be registered, upon which it would be converted into a Finnish government bond that paid 2% interest per year, to be repaid four years later, in 1949. It was illegal to try and spend right halves or transfer their ownership to anyone else (although it's not apparent how this was enforced).

In theory, turning right halves into bonds would shift a large part of the Finnish public's post-war consumption intentions forward to 1949, when the bonds could finally be cashed. By then, the economy would have fully transitioned back to a civilian one and would be capable of accepting everyone's desired consumption spending without hyperinflation occurring.

To our modern sensibilities, this is a wildly invasive policy. Had setelinleikkaus been proposed in 2022-23 as a way to dampen the inflationary effects of the reopening of COVID-wracked economies, and we all had to cut our dollar bills or yen or euros in half, there probably would have been a revolt.

With the benefit of hindsight, we know that setelinleikkaus didn't work very well. Finland continued to suffer from high inflation in the years after the war, much more so than most European countries did.

Why the failure? As Finish economist Matti Viren has pointed out, the reform only affected banknotes, not bank deposits. This stock of notes only comprised 8% of the total Finnish money supply, (Finns being  uncommonly comfortable with banks) so a major chunk of the monetary overhang was left in place.

Another glitch appears to have been the public's anticipation of setelinleikkaus. According to
former central banker Antti Heinonen, who wrote an entire book on the subject, banks began to advertise their services as a way to avoid the dangers of the upcoming monetary reform (see images below). So Finns deposited their cash prior to the final date, the monetary overhang to some degree evading the blockade.

Finnish bank advertisements warning of the upcoming note cutting
Left: "Bank accounts are fully secured in the banknote exchange."
Right: "Depositors are protected."
Source: Hallitus kansan kukkarolla, by Antti Heinonen (Translations via Google Translate)

If the Finnish experiment was a dud, other European responses to the post WWII overhang — either  redenominations, temporarily blocking of funds, or all-out write offs of bank accounts — were more successful. Germany's monetary reform of 1948, which introduced the Deutschmark and was later dubbed the "German economic miracle", is the one that captures the most attention, but here I want to focus on a lesser known reform.

Belgium's Operation Gutt, named after Belgium's Minister of Finance, Camille Gutt, was the earliest and perhaps the most dramatic of the post-war monetary operations. Taking place over four days in October 1944, Belgium contracted its entire money supply, both banknotes and deposits, from 165 billion to 57.5 billion francs. That's a two-thirds decline! You can see it illustrated in the chart below, along with the monetary reform enacted by the Dutch the following year, inspired by the Belgians.

A chart showing the incredible contraction of Belgium's money supply in 1944
Source: Federal Reserve Bulletin, October 1946 (red arrow is my emphasis)

It's not just the size of Operation Gutt that is striking to the modern eye. It's also the oddity of the tool being used. Today, we control inflation with changes in interest rates, not changes in the quantity of money. To soften the effect of the global COVID monetary overhang, for instance, central banks in the U.S., Canada, and Europe began to raise rates in 2022 from around 0% to 4-5% in 2024. 

By making it more lucrative for everyone to save and less attractive to borrow, central bankers were trying to reduce our propensity to spend our COVID support payments, and with less spending, prices wouldn't get pushed up as fast. This reliance on interest rates as our main tool of monetary policy is a relatively new phenomenon. In times past, central banks tended to lean heavily on changes in the supply of money, which may explain why in 1945, their main response — in Europe at least —  was to obliterate the public's money balances rather than to jack up interest rates to 25% or 50%.   

It's worth exploring in some more detail how Operation Gutt was designed. On October 9, 1944, Belgian bank depositors had 90% of the money held in their accounts frozen, leaving just 10% in spendable form.

As for holders of banknotes, there was no Finnish-style cutting. Rather, Belgians had four days, beginning October 9, to bring all their banknotes to the nearest bank, only the first 2,000 francs qualifying for conversion to newly printed versions. All notes above that ceiling got blocked in a separate account (along with excess deposits), some of which would be released slowly over the next few years—while the rest would remain frozen forever, subject to whether the owner was deemed to have been a collaborator who got rich during the occupation. (Finland's setelinleikkaus also had this same "cleansing" motivation.)

In 1944, a line forms at the National Bank of Belgium to exchange notes.
Source: National Bank of Belgium on Flickr

In this sense, the post-WWII European monetary reforms were not only designed to reduce inflation, but also had a moral basis. Think of them as progenitors to India's 2016 demonetization, which was designed to catch so-called "black money," although it failed to do so.

Did Operation Gutt work? Incredibly, the decimation of two-thirds of the money supply in just a few days did not cause an immediate fall in Belgian prices. According to Belgian economic historians Monique Verbreyt and Herman Van der Wee, the Belgian retail price index stood at 260 the month of the reform, but had risen to 387 by September 1945. So it would seem that the whole operation failed. This surely draws into question the quantity theory of money, one of the basic tenets of monetary economics. A decline in the money supply, all things staying the same, is supposed to cause a fall in prices. Here is a glaring case in which it didn't.

However, the National Bank of Belgium (NBB), the country's central bank, strikes a more constructive tone. In a recent retrospective on Operation Gutt, the NBB describes the reform as a gamble that paid off over time, eventually inspiring the "Belgian Economic Miracle", a period of low inflation and fast growth lasting from 1946-1949. By contrast, France did not embark on its own monetary reforms, the NBB takes pains to point out, and it thereby "paid the consequences of post-World War II inflation well into the 1960s." Belgium's inflation rate was also much lower than Finland's in the four or five years after the war. 

Which gets us back to Finland. Unlike the Belgian central bank, Finland's central bank — Suomen Pankki — notably avoids almost all mention of its post-war reform on its website. According to Matti Viren, setelinleikkaus led to "distrust towards the authorities and economic policy for decades," so there may be some sheepish reticence on the part of the central bank to draw attention to it.

But setelinleikkaus and Operation Gutt aren't just archaic monetary policy dead-ends. One day I suspect they'll be back. Not just as a special tool for responding to emergencies, but as a day-to-day policy wrench, albeit in a new and refined form. 

Cash, which is awkward to immobilize for policy reasons, will be gone in a decade or two, leaving the public entirely dependent on bank deposits and fintech balances which, thanks to digitization and automation, can be easily controlled by the authorities. To rein in a jump in inflation, central bankers will require commercial banks and companies like PayPal to impose temporary quantitative freezing on their clients'  accounts, but unlike Finland's 1945 blockade, the authorities will be able to rapidly and precisely define the criteria, say by allowing for spending on necessities — food, electricity, and gas— while embargoing purchases of luxury cars and real estate.

The future version of setelinleikkaus won't be clumsy, it'll be a precise and surgical inflation-fighting tool, albeit a controversial one.

One country, two monetary systems

I often write about odd monetary phenomena on this blog. Here's a new contender, Yemen's dual banknote system.

Yemen uses the Yemeni rial as a unit of account. As one of the poorest countries in the world, Yemen still relies mostly on banknotes to make transactions, which are issued by the Central Bank of Yemen, or CBY.

One of the convenient features of banknotes is their fungibility. This means that one banknote is perfectly interchangeable with another. For a few months now, something strange has happened to Yemen's banknotes. Old rials and new rials have ceased to be fungible. Any rial note that was printed prior to 2016 is now worth around 10% more than newer rial notes.

More generally, the entire Yemeni monetary system has split on the basis of banknote age. From a Western perspective, it would be as if every single U.S. banknote issued with a Steve Mnuchin signature on it, the current Treasury Secretary, were worth 10% less than bills signed five years ago by his predecessor Jack Lew.

Conflicts are always complicated. What follows is a short but drastically simplified explanation of how Yemen's banknote problem began.

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In 2014, the northwestern part of Yemen was taken over by rebel Houthis. They also managed to capture the capital, Sana'a. Meanwhile, an internationally-recognized government occupies the south, the port city of Aden being its capital. Very few people live in eastern Yemen.

Source: Aljazeera

The Central Bank of Yemen has always been located in the capital, Sana'a. It tried to be a neutral party between the two warring sides. This sounds like it must have been a very awkward role to play.

For instance, before the war started the central bank was responsible for paying government salaries, including the army. When the war kicked off some soldiers supported the rebels in the north while others joined the internationally-recognized government in the south. According to Mansour Rageh & coauthors, this meant that the central bank was simultaneously paying the salaries of both sides of the conflict. That's touchy.

This balancing act eventually broke down in 2016 when the internationally-recognized government forced the central bank to move to Aden. Rageh et al explain how this happened. In short, the government convinced the international community to block the Sana'a branch's access to foreign reserves. It also prevented the branch from getting new banknotes printed.
 
So by late 2016 we've got two different branches of the central bank, one controlled by the rebels and the other by the internationally-recognized government. The latter controls most monetary functions.

With the stage set, we can now start to get into the meat of why old rial notes are worth more than new ones. After the Aden branch of the CBY had established itself in 2016, one of the first things it did was order a bunch of new banknotes to be printed up by Russian note printer Goznak. These arrived in Aden in early 2017. They looked like this:

Source: Banknote News

You can see that there are some differences between the new 1000 rial note and the old one, pictured below:

Source: Banknote News

The rebels were not happy with the new notes. It's easy to guess why. Fresh money could be used to pay government fighters, not rebel fighters. This "blood money" would then cheekily flow north via trade. Since anyone who holds a banknote is by definition funding the government that issues it with a no-interest loan, the rebel north was financing its own enemies. (The technical term for this sort of financing is seigniorage).

In 2017, the rebels began to limit the ability of northern civilians to use the newly issued banknotes. This mostly affected banks and other large businesses in the northern Yemen, which were now required to avoid dealing in the new notes. Anthony Biswell of the Sana'a Center for Strategic Studies has a much weightier explanation of this transition. Do read his article if you want to learn more about this topic.

Anyways, on December 18, 2019 the rial spat crescendoed into a full out ban. The rebel government announced that everyone in the north had thirty days to turn over new notes at any of 300 agents located across the region. In return they would get an equivalent amount of old banknotes, if available, up to 100,000 rials per person. That's around US$170.

Anything above this 100,000 rial limit would have to be converted into a digital rials. These would be supplied by one of three privately provided electronic wallets. Unfortunately, Yemen has almost no digital payments infrastructure, so these balances wouldn't be of much use.

Thanks to the December 2019 ban, the price of old and new rial banknotes has completely diverged. Below is a chart from the World Bank.

Source: World Bank

We can surmise why a big gap has developed between the two types of notes. The stock of old pre-2016 banknotes is fixed. It can't grow. But the supply of new banknotes is not fixed. The Aden branch of the CBY can get Goznik to print as many notes as it wants. So the rare rials, the old ones, are worth more.

I'd expect Gresham's law to kick in, too. Gresham's law says that if a government stipulates that two payment instruments are to circulate at the same rate, but one is worth fundamentally more than the other, then the "bad" one drives out the "good". More specifically, the undervalued money will be hoarded (or exported), leaving only the overvalued one in circulation.

In Aden's case this is likely to translate into "bad" rials (the post-2016 ones) driving "good" rials (the pre-2016 notes) out of circulation. Since the Aden government treats both old and new banknotes as interchangeable, but old ones are worth more, the old ones will all be exported to the north.

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Where might all this lead? With the Sana'a branch having declared war on new notes, the Aden branch may do the opposite and try to hurt the old ones. This would involve orphaning all of its pre-2016 banknotes. That is to say, the Aden branch will demonetize them; cease accepting old notes as its liability or obligation.

But even if they were to be demonetized, orphaned rials would still circulate.

The topic of "orphaned" currency has popped up before on this blog. The Somalian central bank ceased to exist in 1991. Yet even though the Somali shilling now lacked a central bank sponsor, they continued to be used in Somalia as a medium of exchange, as recounted by Will Luther here.

A new Somali central bank has stated that it will re-adopt these old shillings and replace them with new currency. To date, this hasn't happened.

Along these same lines, even though Saddam Hussein disowned Iraqi dinars that had been printed in Switzerland, these so-called "Swiss Dinars" continued to circulate in northern Iraq. After Saddam was deposed by the Americans in 2003, the new central bank re-adopted all of the orphaned Swiss dinars.

If the Aden government is going to disown old Yemeni rials, I wouldn't expect them to remain orphaned for long. The Sana'a branch of the Central Bank of Yemen would quickly adopt them as their own obligation. At which point Yemen's unofficial two-currency system would become official. The Sana'a branch might even try to get its own version of the rial printed up. If so, it would have to rely on printers other than Goznak.

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Yemenis already face so many difficulties. The sudden emergence of a dual-currency regime only compounds their plight. Prices are a language. We become fluent in this language as we engage in our commercial habits of buying, selling, and appraising. The sudden rial split forces Yemenis to start "speaking" in two different price arrays (three if the U.S. dollar is included). It's terribly inconvenient.

There are also costs to renegotiating rial-denominated debts. If one Yemeni owes the other, are they to pay in old rials or new ones? Debtors will always prefer the debased currency, new rials, but creditors will ask for the stronger one, old rials. Somehow a decision will have to be made.

Finally, a dual currency regime means that Yemenis will be forced to convert from one type of currency to another to make payments. That means incurring fees, hassles, and waiting time.

In the west, we take fungibility for granted. To achieve monetary standardization, a big investment in technology and coordination is required. The fact that a dollar is worth the same in Los Angeles as it is in New York, or Vancouver as it is in Halifax, is worth celebrating.

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P.S. Yemen's old rials are really old. See image below. Dilapidated banknotes are a major problem. They make trade harder and allow for easier counterfeiting.

ولا شي لا تفتجعش، بياس ابو خمسين pic.twitter.com/ljMmZuTxjY

— فرانز عبدالستّار النمساوي (@DerOsterreicher) May 20, 2020

Getting up to monetary mischief

By Harcourt Romanticist [source]

This post is dedicated to the protesters in Hong Kong. I am awed at how courageous they have been in the face of continuing pressure from China's Communist party. The same regime is complicit in persecuting Uighur Muslims and imprisoning two Canadians, Michael Spavor and Michael Kovrig.

There are all sorts of creative forms of non-violent mischief that citizens can use to protest against oppressive governments. This post explores a sub-category of non-violent mischief: monetary mischief.

Money stamping

One of the most popular forms of monetary protest is to overstamp currency. This involves stamping banknotes or countermarking coins. Coins and banknotes are vital to trade and circulate widely. Which makes them a great way to advertise a cause or complaint. The message automatically propagates itself via hand-to-hand commerce.

The monetary authorities will react to the threat by hastily withdrawing marked notes and coins from circulation. When bills or coins enter the wholesale cash system—i.e. when they are collected by banks, cash-in-transit firms, or ATM companies—they are typically sorted by machines (or hand) for fitness. Defaced currency will get filtered out and returned to the central bank (or mint) to be destroyed and replaced.

This form of protest goes far back in history. For instance, below is a photo of a 1903 penny that has been defaced with a suffragette rallying cry:

"It was said at the time, that the suffragettes had copied the practice from anarchists, who were defacing similar coins with the phrase ‘Vive l’Anarchie’." Source: British Museum

Wayne Homren, editor of E-Sylum, has recently explored some modern U.S. examples of money stamping as protest:

Source: E-Sylum

Source: E-Sylum

Here are a few examples from Ireland during the Troubles:

© Fitzwilliam Museum. "The one illustrated in Figure 6 is a 1971 UK two-pence which has been stamped with ‘SMASH H BLOCK 8' on the obverse bust. The H-blocks at the Maze/Long Kesh prison housed prisoners convicted of scheduled offences after 1 March 1976, with H-block 8 reserved for IRA prisoners. The hunger strikes of 1981 came in protest at the removal of Special Category Status from prisoners and led to the deaths of ten IRA hunger strikers." Source: Richard Kelleher, Money and Medals Newsletter 77

Hong Kongers still use plenty of cash. Which would seem to make Hong Kong ideal for money stamping. However, I haven't seen many examples of this form of mischief being used by Hong Kong protestors. About the only evidence I've located is provided below. It is a warning from a Thai money changer that it will not accept Hong Kong notes that have been stamped with political messages:

Source: Facebook

Which leads directly into my next point. For every form of monetary mischief, the authorities have a defence. The simplest line of defence against overstamping is to declare the practice illegal. Luckily for protestors, it is almost impossible to enforce this law. Money stamping can be safely performed behind closed doors. If a money stamper is caught passing along a note or coin, they can just say they accidentally received it as change or from an ATM.

A more effective line of defence is to declare that any stamped banknote is henceforth no longer money. This is basically a form of demonetization, a very focused one. To initiate this defence, the central bank refuses to accept any note or coin that has been altered. Good bills can continue to circulate. If the central bank refuses to accept marked bills, then wholesalers like banks (and forex dealers like the Thai one above) will likewise refuse, and so retailers won't accept it. And so angry members of the public who have stamped their notes with protest messages will find that their cash has become unspendable.

To avoid being left out of pocket, protesters will avoid stamping their currency in the first place. Which is why this line of defence is fairly effective.

Small, not large denominations

Protestors have a good counter to the threat of demonetization. They can focus on stamping large amounts of small denominations, not small amounts of large denominations. In Canada and U.S., the relevant small denominations are $1 coins/bills, $2s, and $5s. In Hong Kong's case, the relevant small denominations would be the HK$10 and HK$20 notes, which are equal to around US$1.20 and US$2.40 respectively. 

There are two reasons for focusing on small notes. First, it is far safer for a student protestor to overstamp a few HK$10 notes. If the notes are to becomes unspendable thanks to a demonetization, the protestor may have to do without a meal at McDonald's. But if a protestor stamps a few HK$1000 (US$126) bills and they subsequently becomes worthless, that will be far more damaging to their finances.

The second reason for focusing on small denomination notes is that their supply is much less flexible than larger denominations. Think about it for a moment. For each $500 that a central bank printing press produces, it takes fifty times the effort to create an equivalent amount of $10s. Which means that it will be harder for the central bank to replace a large amount of defaced $10s than to replace an equivalent value of defaced $500s.

This difference in replacement rates is important. When notes that have been stamped with political slogans are declared void by the monetary authorities, the supply of banknotes will be reduced. A shortage has been created. The central bank can quickly remedy a shortage of large denominations like HK$500s. But fixing a shortage of HK$10s will take more time. The monetary authorities are left with a choice. They can either allow the shortage of small denomination notes to continue, or they can bring it to an end by re-allowing defaced notes to circulate.

Either way, the government ends up looking bad. Shortages of change are extremely inconvenient to businesses. Those in charge will be derided as incompetent. But allowing small denomination defaced notes to return to circulation will allow the protesters to continue advertising their cause.

Cashing out of bank accounts

A second form of monetary protest is mass cash-outs of bank accounts. In 2010 Eric Cantona, a former French footballer, started to champion this form of mischief. I'm pretty sure he wasn't the first to come up with the idea. (Anyone else have prior examples?). Anyways, here he is:

"We don't pick up weapons to kill people to start the revolution. The revolution is really easy to do these days. What's the system? The system is built on the power of the banks. So it must be destroyed through the banks.

"This means that the three million people with their placards on the streets, they go to the bank and they withdraw their money and the banks collapse. Three million, 10 million people, and the banks collapse and there is no real threat. A real revolution."

"We must go to the bank. In this case there would be a real revolution. It's not complicated; instead of going on the streets and driving kilometres by car you simply go to the bank in your country and withdraw your money, and if there are a lot of people withdrawing their money the system collapses. No weapons, no blood, or anything like that."

Last January French protestors, the gilets jaunes, gave it a try.

How effective are mass cash withdrawals?

Banks rely on multiple sources of funding, one of which is its base of retail depositors. They also tap investors (who buy their bonds and shares) as well as depositors from the government and corporate sectors. If a portion of their retail depositors close their accounts, this will probably hurt the banks. But given the diverse nature of bank funding, I think Cantona overplays his hand when describes it as a "really easy revolution."

Banks also have access to the most powerful lender of all, the central bank. If protestors do succeed in pressuring certain banks with a cash-out campaign, the central bank will step in and support the targeted bank by lending it funds. Since the bank is being pressured for political reasons, and not because it is fundamentally unsound, the central bank will be quite liberal in support. Ultimately, central bank support should staunch the run.

Like the gilets jaunes in France, protestors in Hong Kong have launched their own cash-out campaign—with a twist. Hong Kong pegs its currency to the U.S. dollar. Not only are protestors cashing out of their bank accounts. They are also converting their Hong Kong funds into U.S. dollars in the hope of pressuring the peg.

Someone please tell my friend Kyle Bass that on LIHKG, HK protestors have started their USD Challenge, in which they are getting cash out of their accts and converting to USD cash. This is going to break the HK banking system and the HKD peg for sure!!!! pic.twitter.com/ix6ANmyzQT

— LFC (@goldencaskcap) August 15, 2019

I combed through Hong Kong Monetary Authority statistics to see if the cash-out campaign is having any effect. Banks and other financial institutions will typically keep a small amount of banknotes and cash in their vaults to satisfy customer redemption requests. Below I chart out the evolution of the cash held by Hong Kong banks by year.

Hong Kong banks always keep some cash in reserve to prepare for customer cash-outs.

They usually only store small amounts in August (~HK$20 billion). Check out the large out-of-season jump in cash holdings this summer (to HK$31 billion) as banks prepare for redemption requests. pic.twitter.com/Rzqo9kmcFr

— John Paul Koning (@jp_koning) October 13, 2019

You can see that Hong Kong banks have currently stocked up on over HK$30 billion in currency, far more than the typical HK$20 billion they tend to hold in August. This amount exceeds the Christmas spike, when the public typically withdraws the largest amounts of cash for purposes of gifts and travel. (Apparently the early 2018 jump may have been related to the installation of facial recognition hardware on neighboring Macau's ATMs).

It's hard to say why cash inventories have spiked. It could be related to banks being worried about protestor-led cash withdrawals. Or alternatively, they may fear that even non-protestors may start to ask for cash-outs, albeit for economic reasons, not political ones.

As I said earlier, I think that cash-out campaigns probably won't have a big effect. Banks have very strong lines of defence. As for attacking the Hong Kong dollar peg, that's quite ambitious. In theory, it would work. But every depositor in Hong Kong would have to participate.

Again, focus on small denominations

If I was to start a monetary protest here in Canada that involved cash withdrawals, I'd set my ambitions lower. The way to make any cash-out campaign more effective is to focus on withdrawing small denomination notes. Go into the bank and ask to withdraw $1/$2 coins and $5 notes. (In Hong Kong, HK$10s and HK$20s instead of HK$500s). Or withdraw large denomination notes from ATMs and then go to stores and ask them to break them for you. If the store won't break them, than buy a $1 chocolate bar with a $20 and hoard the change.

Earlier, I mentioned that the supply of small denomination notes is not as elastic as the supply of large ones. By way of illustration, I've provided a screenshot of Hong Kong's cash supply:

Source: Hong Kong Monetary Authority annual report [link]

Like most countries, Hong Kong has far more small denomination notes and coins in circulation than large ones. As the chart on the right shows, the HK$10 and HK$20 constitute 11.6% and 35.7% of all bills in circulation. But the total value of these small denomination notes tends to be quite small, as the left chart illustrates. They comprise just 0.6% and 3.5% of total banknote value. You can see the same distribution in Canada, too. The value of $100 bills dwarfs the $5 bill, but we've got about the same amount outstanding.

So there are a boatload of small denomination banknotes in circulation that are responsible for bearing a large load of the nation's transactional work. But the combined value of these work-horse notes is quite low.

This set of features makes small denomination currency an easy target for a would-be monetary protestor. A motivated group of Canadians could conceivably hoover up a large share the small denomination note and coin supply, thus creating a shortage of change. If enough people participate, the Bank of Canada's printing press would not be able to keep up. This would impede the ability of the Canadian payments system to facilitate transactions.

Most people have forgotten what small change shortages look like. But anyone who has read a bit of monetary history will know that many of the large monetary disturbances in the last five or six centuries leading up to 1800 were coin shortages. They were a nuisance.

In this post I've explored two types of non-violent monetary mischief that protestors have turned to in the past. I'm sure there are more. For instance, I haven't mentioned any digital types of mischief. In the comments below, feel free to provide some examples. As for the Hong Kongers who my be reading this, I wish you the best. Hang in there.

Swedish betrayal

I recently wrote two posts for the Sound Money Project about Swedish monetary innovation. The first is about an effort by the Swedish central bank—the Riksbank—to force retailers to accept cash, and the other is about the e-Krona, a potential Riksbank-issued digital currency.

This post covers a third topic. For many years now those of us who are interested in cash, privacy, and payments have had our eye on Swedish banknote demand. The amount of paper kronor in circulation has been declining at a rapid pace. Many commentators are convinced that this is due to the rise of digital payments. Since Sweden is at the vanguard of this trend, it is believed that other nation's will eventually experience similar declines in cash demand too.

But I disagree. While digital payments share some of the blame for the obsolescence of paper kronor, the Riksbank is also responsible. The Riksbank betrayed the Swedish cash-using public this decade by embarking on an aggressive note switch.  Had it chosen a more customer friendly approach, Swedes would be holding a much larger stock of banknotes than they are now. As long as other countries don't enact the same policies as Sweden, they needn't worry about precipitous declines in cash demand.

Banknotes are dead, long live banknotes

Across the globe, an odd pattern has played out over the last decade. The proportion of payments that are being made with cash has been rapidly declining thanks to the popularity of card payments. Sweden is no different in this respect, although it may be further along than most:

Source: Reserve Bank of Australia

Oddly, even as developed countries are seeing fewer transactions completed using cash, the quantity of banknotes outstanding has jumped. This increase in cash outstanding, which generally exceeds GDP growth, is mostly due to an increase in demand for large-value denominations, as the chart below illustrates:

Source: Bank for International Settlements

The BIS has a good explanation for this seemingly contradictory pattern. The demand for cash can be split into two buckets: means-of-payment and store-of-value. Banknotes earmarked as a means of payment are generally spent over the next few days. Demand for this type of cash is stagnating thanks to increased card usage. Not so the former. The demand to store $100 bills under mattresses and in safety deposit boxes in anticipation of some sort of disaster is booming. According to the BIS, this is due in part to low interest rates, which makes banknotes more attractive relative to a bank deposit or government bond.

The number of banknotes held as a store-of-value demand accounts for quite a large proportion of total cash in circulation. In a recent paper, Reserve Bank of Australia researchers estimated that 50% to 75% of Australian banknotes are hoarded as a store of value. Keep in mind that these sorts of calculations are subject to all sorts of assumptions. Australia's experience with cash probably applies to most other developed nations.

Sweden, a sign of what's to come?

Which gets us back to Sweden. Sweden differs from all other nations because of what is happening with its banknote count. The quantity of paper kronor outstanding has been consistently plummeting for a decade now, and currently clocks in at just half its 2008 tally:

Surprising, but for the first time in years, the number of Swedish krona banknotes in circulation is growing.

Has Sweden's push to become a cashless society come to an end? pic.twitter.com/T6l1q40Ssu

— JP Koning (@jp_koning) November 6, 2018

Even Norway, which has probably proceeded further along the path of digital payments than Sweden, has experienced only a small decline in notes outstanding, nothing akin to Sweden's white-knuckled collapse. The key question is this: why have most developed nations experienced digital payments renaissances along with stability in cash demand, whereas Sweden's own renaissance has been twinned with a seismic drop in cash demand?

The answer to the question is important. Many commentators (including Ken Rogoff) are convinced that the rest of the world's nations will eventually find themselves in the same situation as Sweden. The allure of digital payments will inevitably lead to an all-out Swedish-style desertion of cash.

I'm not convinced. As I mentioned at the outset of this post, the Riksbank shot itself in the foot by carrying out an aggressive currency swap between 2012-2017. This swap did incredible damage to the paper kronor "user experience", or UX. In response, discouraged Swedes fled from cash and substituted into less awkward alternatives like bank deposits. Let's take a closer look at Sweden's 'great note switch'.

The 'great' note switch

Every decade or two central banks will roll out new banknotes with updated designs and anti-counterfeiting measures. This is good policy since it cuts down on fake notes. These switches are generally carried out in a way that ensures that the public's user experience with cash remains a good one throughout. The best way to maintain cash's UX during a changeover period is to allow for long, or indefinite periods of concurrent circulation between old and new notes. Concurrent circulation cuts down on confusion and hassle endured by note users.

Let me explain with an example. Up here in Canada, the Bank of Canada introduced polymer banknotes between 2011 and 2013. But no time frame was placed on the demonetization, or cancellation, of previous paper $5, $10, $20, $50, and $100 notes. Since we all knew from the get-go that we would be free to spend or deposit old Canadian banknotes whenever we got around to it, we didn't have to go through the hassle of rounding up old notes stored under our mattresses and bringing them in for new ones. Apart from the novelty of polymer notes, we hardly noticed the switch to polymer.

Not so with Sweden's rollout of new banknotes. Rather than allowing for a long period of concurrent circulation between old and new notes, the Riksbank announced a shot-gun one-year conversion window for legacy notes. After that point, all old notes would be declared invalid.

For instance, the new 20, 50, and 1000-krona notes were all introduced on October 1, 2015. Swedes had until June 30, 2016—a mere 273 days later—to spend the old notes at retail outlets, after which it was prohibited for retailers accept old notes. If they had missed that window, the Swedish public then had another 62 days—till August 31—to deposit them in banks. After that, all old 20, 50, and 1000 notes would invalid. Owners of invalid banknotes could bring them to the Riksbank, fill out a form explaining why the due date had been ignored, and for a fee get valid ones.

The same shot-gun approach characterized the rollout of the new 100 and 500 the following year. Swedes had 273-days to spend old 100 and 500-krona notes, and another 365 days to deposit them at banks.

I've pasted the time frame for the entire conversion below:

Source: Riksbank

The October 2015 and 2016 switches were preceded by a preparatory demonetization in 2012. At the time, Sweden had two types of 1000-krona note in circulation. The version that had been introduced in 2006 had a special foil strip to combat counterfeiters, but the 1989 version did not. In November 2012 the Riksbank announced that Swedes would have 418 days—till Dec 31, 2013—to use old 1000 notes without foil strips. After that date the notes would be invalid.  

That outlines Sweden's hectic changeover timeline. Now, let's go back to 2012 and put ourselves in the shoes of Hakan, a Swede who has stashed a few 1000-krona banknotes in anticipation of emergencies or other exigencies. In 2012, Hakan would have learnt that all of his 1000-krona notes without foil strips would have to be replaced or declared invalid.

How to deal with this annoyance? Hakan could have replaced them with 1000-krona notes with foil strips, but the Riksbank had also communicated that notes with strips were to be invalidated by 2016. Replacing them with 500 notes would be equally inconvenient, since these were scheduled to be replaced in 2017. Rather than committing himself to a string of inconvenient switches, Hakan may have simply given up and deposited his notes in a bank.

Below I've charted the evolution of Sweden's notes-in-circulation by denomination:

Note the massive 50% decline in 1000-krona notes outstanding between the end of 2012 and 2013. Granted, the 1000-krona was already in decline prior to then. But without the aggressive 2012-13 demonetization, this decline would have been much less precipitous.

Even more glaring is the drop in the number of 500-krona notes beginning in 2015 as the conversion period approached. Rather than swapping old 500-krona notes for new ones, or 1000-krona notes, Swedes instead choose to deposit them in the bank. After enduring a stream of inconvenient note exchanges, were cash users like Hakan simply sick of their product expiring on them? 

A natural experiment: Norway v Sweden

Neighbouring Norway serves as a good control or benchmark for studying Sweden. Both nations have similar tastes for digital payments and cash, identical banknote denomination structures, and their currencies trade close to par. But unlike Sweden, Norway did not implement a massive note replacement effort. This gives us some clues into how Sweden's switch may have affected demand for the paper kronor.

Below I've separately charted the evolution in the value of each nation's stock of 500 and 1000 notes, and the combined large denomination note stock (1000s + 500s).

During the 2015-2017 changeover period, demand for Sweden's 500-krona note plummeted, but uptake of the Norway's 500-krone note continued to grow nicely (first chart). The aggressive demonetization of 2012-13 coincided with a big drop in the quantity of Swedish 1000-krona notes. Meanwhile, the rate of decline in the quantity of Norwegian 1000-krone notes continued as before (second chart). What message do I take from these two charts? Given two otherwise equal nations, the one that subjects its citizens to an aggressive note swap will experience a large decline in the popularity of the targeted note.

As for the last chart, the total value of Swedish high denomination banknotes was once twice that of Norway's count. But it is now equal to that of Norway, despite the fact that Sweden has twice the population. My guess is that if the Riksbank hadn't inflicted a series of aggressive demonetizations on Swedes, folks like Hakan could have blissfully ignored the entire changeover, and Sweden would still have a much bigger note count than Norway. The black dotted line gives a hint of where Sweden might be now if the pre-changeover trend in kronor banknote demand had continued.

Why did the Riksbank betray the Swedish public?

Why didn't the Riksbank adopt the same policy as the Bank of Canada during its own massive note switch? In the charts above its quite easy to point out when the 500-krona and 1000-krona notes were replaced. But try spotting when Canada switched from paper to polymer banknotes:

You can't, because it was a gentle switch, one that didn't hurt cash's UX.

Patriotic Swedes might counter that Sweden isn't Canada, it has its own way of doing things. But during previous Swedish note introductions, long windows of concurrent circulation were the standard. For instance, when the 1000-krona note that was printed from 1952-1973 was replaced by a new 1000 note in 1976, the legacy note remained valid for more than ten years after that, until Dec 31, 1987. And when the next series of 1000-krona notes was rolled out in 1989, the legacy note was accepted until December 1998. Long windows, not short ones, is the Swedish tradition.

A March 2018 report from the Riksbank entitled Banknote and coin changeover in Sweden: Summary and evaluation gives some insights into why a shot-gun switch was chosen instead of a user-friendly approach. Very early on the process, the Riksbank began to consult with firms involved in the movement of cash including the BDB Bankernas Depå AB (a bank-owned cash depot operator), the Swedish Bankers’ Association, the larger banks, ATM operators, and others. One of the questions that was discussed was how long the old banknotes should remain valid. In April 2012, these market participants submitted their preferred timetable for the changeover. One of their preferences was for:

"...the old banknotes and coins to become invalid after a relatively short period so that they could avoid having to manage double versions of the banknotes and coins for an extended period."

These same market participants also requested that the Riksbank demonetize the old 1000-krona notes without foil strips. Removal of this older series meant one less version to manage once the new 1000-krona note was debuted in 2015. Market participants also hoped that the old banknotes wouldn't be exchanged for new ones, thus reducing the total amount in circulation. If you are wondering why bankers might want fewer banknotes outstanding, go read my 'conflict of interest' section a few paragraphs below. 

The timetable that ended up being adopted by the Riksbank in May 2012 was basically the same one proposed by industry. So there you go. The Riksbank introduced a shot-gun approach because that's what Swedish bankers wanted. But in designing the changeover to be convenient for banks, the Riksbank threw the Swedish public under the bus. Nor was it unaware of the inconvenience it was imposing on Swedes. According to the March 2018 report:

"The Riksbank was aware that the timetable would lead to complications for the general public in that there would be a number of different dates to keep track of. The need for information activities would be increased. However, the Riksbank considered that the interests of the cash market were more important..."

Now, if the Riksbank had justified the shot-gun switch as a way to flush tax cheats out, I might be more sympathetic. At least an argument could be made that the public's welfare was being served by imposing a series of inconveniences on them. But as the above quote indicates, the motivations for quickly invalidating old notes was much less nuanced than this. The Riksbank deemed that the 'complications' that the general public had to endure simply weren't as important as the 'interests' of the banks. Full stop.

There is a huge conflict of interest involved in consulting with banks about cash's future. Sweden's bankers would have been quite pleased to provide the most awkward timetable imaginable. After all, they would have been the main beneficiaries. The more Swedes who forsake cash to pay with cards, the more fees banks earn. Furthermore, each kronor that is held in the form of cash is a kronor that isn't held at a bank in the form of a deposit. Banks lust after consumer deposits because they are a low-cost source of funding. One wonders if the Riksbank fully understood this conflict of interest.

Notes for the future

The decline in the kronor count has finally been reversed. In the tweet I embedded above, the amount of paper kronor in circulation rose in 2018, the first increase in many years. The impositions on the the kronor's UX over the last five years are finally drawing to a close. Now that they no longer have to worry about timetables and expiry dates, are Swedes like Hakan finally returning to the market?

The great irony is that the Riksbank, having caused a big chunk of the decline in 1000 and 500-krona note usage, is suddenly getting quite worried about this trend. Earlier this year, Riksbank governor Stefan Ingves lamented that

"There are those who think we have nothing to fear in a world where public means of payment have been replaced completely by private alternatives. They are wrong, in my opinion. In times of crisis, the general public has always sought refuge in risk-free assets, such as cash, that are guaranteed by the state. The idea of commercial agents shouldering the responsibility to satisfy public demand for safe payments at all times is unlikely."

The Riksbank may even roll out an e-Krona, a digital currency designed to meet Swede's desire for "continued access to a means of payment that is risk-free and guaranteed by the state." Odd that Ingves is now so concerned about Swedish access to a risk-free payments medium when he was so willing to ignore the interests of Swedish cash owners just a few years before.

Sweden will probably have to go through another note switch sometime in the late 2020s. I hope that when it comes, Swedish bankers will get a little bit less representation at the table and the Swedish public a bit more.

As for concerned citizens and central bankers in other countries that are planning to introduce new notes, we can all learn some lessons from Sweden's 2012-2017 changeover. Aggressive note switches may be good for private bankers, but they hurt cash-using citizens.  The long-window approach to note switches, not Sweden's shot-gun method, is the customer-friendly approach.

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Dedicated to my favorite Swedish hockey player:

The demonetization gap

Two years ago, Indian PM Narendra Modi suddenly demonetized all of the nation's ₹1000 and ₹500 banknotes. His stated goal was to exact justice on all those holding large amount of dubiously-earned cash. But since these two denominations constituted around 85% of India's currency supply, the demonetization immediately threw the entire nation into chaos.

After suffering from a nine-month note shortage, enough new notes were printed to meet India's demand for cash. But in the interim, what had happened to Indians' demand for cash? Did their experience with demonetization lead them to hold less cash than before, or did they simply revert to their pre-demonetization habits and patterns? I wrote an article in September 2017 dealing with these questions. With another year having passed we now have more data—so I'm going to provide quick update.

My claim is that a demonetization gap continues to exists. This gap is evidence that the cancellation of ₹1000 and 500s has had an enduring effect on Indians' behaviour surrounding cash.

To measure the gap, we need to compare the evolution of India's cash supply to the path it would have taken in a world in which Modi's demonetization never occurred. We know that the supply of rupee banknotes grew at an average rate of around 12.3% from 2011 to 2016, and on the eve of demonetization there were around ₹17.5 trillion in banknotes and coins in circulation. Taking these numbers and extrapolating forward, November 2018's cash-in-circulation count would have clocked in at around ₹21.5 trillion rupees had the demonetization not occurred. But in our actual world, the one where demonetization occurred, India's cash count registers at just ₹19.5 trillion rupees.

So thanks to demonetization, Indians are holding around ₹2 trillion fewer paper rupees than they otherwise would have. I've illustrated the demonetization gap below:

Today is the two-year anniversary of Modi's rather inept demonetization.

Interestingly, the demonetization gap—the difference between India's current banknote count and where it probably would have been without demonetization—is still quite large... pic.twitter.com/DvUnOlEjim

— JP Koning (@jp_koning) November 8, 2018

What sort of assumptions do we need to make in order for the demonetization gap to be zero? Let's say that demonetization had never occurred. To get from a currency stock of ₹17.5 trillion in November 2016 to ₹19.5 trillion by November 2018, we need to assume an absurdly low 6% growth rate for the stock of currency stock. I doubt India has ever experienced such a slow growth rate in cash-in-circulation. So while you can quibble with the size of the gap, I think it's undeniable that some sort of gap exists i.e. demonetization has had long lasting effects on cash holdings.

There are two potential explanations for why a demonetization gap exists. My guess is that both are to some extent true, although as time passes the influence of the second will tend to disappear:

1. Demonetization might have had a permanent effect on Indians' taste for cash. Prior to demonetization, a money launderer might typically have built up an inventory of ₹100 lakh (US$135,0000) worth of banknotes before laundering them. But the demonetization frightened him, so now he launders his ill-gotten gains whenever he holds just ₹50 lakh worth of notes.

Or maybe a family that typically conducted most of their day-to-day transactions in cash opened a bank account during demonetization so that they could deposit their notes. And now they've fallen into the habit of paying for half their family expenses with cash, and the other half with debit cards.

These sorts of changes to transactions preferences would get expressed in the nation's overall stock of notes by a reduction relative to trend.

2. Demonetization might have caused large and lasting damage to the informal sector of the Indian economy. With 85% of the nation's money stuck suddenly came unusable, and so many businesses dependent on cash, these businesses may have been forced to go under. With informal production cratering, fewer banknotes would be required for transactions purpose than would otherwise be the case. Over the long term, however, one would expect these sectors to rebuild, any drag they had once placed on cash demand being removed.

If Indian's taste for cash changed, how might these new tastes have manifested themselves? Did Indians swap cash for deposits in the regulated banking system or did they simply swap one form of anonymous "black money" for another (i.e. cash for gold, diamonds, real estate)? In my post from last September I found some interesting charts. I'm going to update them below.

As the chart above illustrates, the number of point-of-sale (POS) terminals installed has experienced a one-time shot to the arm after the November 2016 demonetization announcement.

The second chart shows that the value of POS transactions using debit and credit cards moved to a new and higher plateau.

The last chart shows the growth in value transacted using mobile wallets. Demonetization gave mobile wallet usage a quick shot to the arm, but it is difficult to determine if growth stayed above trend in 2017-18 or below. Given that mobile wallets are recent and started from a very low base, usage had already been growing very fast before demonetization.

In any case, I think the charts provide at least some evidence that the shift out of cash has been captured by digital finance.

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The existence of a demonetization gap does not mean that Modi's effort was a success. If someone comes up with a great monetary innovation, expect it to be quickly copied. Polymer banknotes, real-time gross settlement systems, and inflation targeting are all examples of monetary technologies that have spread from their original adopter to the rest of the world. But not a single nation has copied India's demonetization. I would be surprised if any ever do. The costs imposed by the event—lost labour time, foregone transactions, chaos—were all too apparent, and its benefits dubious.

That being said, I sympathize with the intuition that was at the core of Modi's demonetization. Let's face it, plenty of people use cash as a way to avoid taxes. These cheats force everyone else to pay more than their fair share for shared infrastructure. It would be nice if there was a way to rebalance the load by taking back resources lost to the cheats. A classic way to fix this problem is to have the tax department hire more inspectors. An alternative is to design the nation's cash system in a way that corrects for any unfairness. Modi's demonetization is an example of the second approach, a massive cash dragnet designed to flush out cheats.

But it was an incredibly clumsy effort. The tricky thing with cash is that it is simultaneously a vessel for tax evasion for a few cheats and also a vital monetary fluid for the many. Punishing the first group means that the second will also be hurt. If the costs incurred by the second group are too high, then the calculus behind the whole effort fails.

Modi's demonetization tried to lessen the blast radius by targeting users of large denomination ₹500 and ₹1000 notes while leaving users of the ₹10, ₹20, ₹50, ₹100, and ₹200 untouched. The motivation behind this was that presumably large tax cheats will concentrate their cash holdings in higher denomination notes, while regular note users will tend to concentrate in the lower denominations. But even with this filter in place, the ₹500 and ₹1000 were so widely held by Indians that the demonetization of these denominations forced a large proportion of the population to endure massive lineups for weeks. Retail trade ground to a halt.

Over the last two years I suggested a few ideas that would have improved the effectiveness of Modi's demonetization. Instead of targeting all ₹500s and ₹1000 notes, demonetizing notes by serial number would have resulted in a much smaller blast radius. Rather than withdrawing ₹500s and ₹1000s, it would have been easier to overstamp them with stickers, and then slowly withdraw these overstamped notes over time. This would have helped prevent massive cash shortages.

But even after these modifications, demonetization is too blunt of a tool to effectively solve the complicated inequities arising from cash-based tax evasion. So should Indians (and the rest of us too) simply live with these imperfections, accepting unfairness as an acceptable cost of maintaining cash systems?

Maybe not. In his paper Taxing Cash, Ilan Benshalom has suggested a less invasive technique for reclaiming resources from cash-using tax evaders. Rather than demonetizing all ₹500 and ₹1000s, Modi could have introduced a recurring withdrawal fee of ₹10 for each ₹500 note and a ₹20 rupee fee on each ₹1000 note.

Imagine that Rohit needs to pay Indira ₹10 lakh. The two can avoid taxes if they agree to transact using cash rather than making a digital payment. So Rohit withdraws one thousand ₹1000 bills from his bank. He incurs a fee of ₹20,000 (₹20 for each note), the bank forwarding the full amount to the government. Rohit might consider avoiding the withdrawal tax by withdrawing ₹50s and ₹100s (which don't incur fees), but he is unlikely to go this route since ₹10 lakh in small denomination notes would be terribly awkward.

The upshot is that Indian tax payers would get ₹20,000 in compensation for Rohit and Indira's evasion of taxes. Compared to Modi's demonetization, the blast radius of a large denomination withdrawal tax is much smaller. Regular Indians could have easily continued about their business using untaxed ₹100s or migrating to digital payments. It sounds promising, but after Modi's explosive demonetization, Indians are probably much less open to new monetary experiments, and who can blame them.

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There are several other ways to visualize Indian demand for cash over time. For instance, here is the cash-to-GDP ratio:

The idea here is that for each unit of GDP, some amount of cash is used as means of circulating production. (Note: While the cash-in-circulation numbers are current, 2018 Q2 nominal GDP has still not been published. I estimated it by assuming 11.5% nominal growth, the average growth rate over the last few years.)

Vivek Dehejia and Rupa Subramanya measure the ratio of cash-in-circulation to the total money stock, or M3. They find little evidence of a reduced reliance on cash. For the chart below, I've used M4 which includes not only chequing and savings deposits held at banks but also total postal office deposits:

The cash-to-M4 ratio is a bit lower than it was on the eve of demonetization. For each ₹100 held in accounts, Indians now only hold ₹14.9 in banknotes and coins, down from ₹16 in October 2016. Be careful with using the cash-to-M4 ratio as a measure of preferences for banknotes. If Indians want to hold fewer deposits and more government bonds, M4 declines, and so the cash-to-M4 ratio will rise. But preferences for cash haven't changed at all.